Economica (2003) 70, 251–265
Wage-setting under Different Monetary Regimes
by STEINAR HOLDEN
University of Oslo and Norges Bank
Final version received 9 November 2001.
In an economy with large wage-setters (like industry unions), the monetary regime affects the
trade-off between consumer real wages and employment and profits faced by the wage-setters.
This paper shows that an exchange rate target, including participation in a monetary union, is
likely to involve lower wages in the traded sector, and higher wages in the non-traded sector,
than does a price target. An exchange rate target also involves higher prices on non-traded
goods relative to on traded goods. Overall welfare is likely to be higher under a price target.
INTRODUCTION
The last few years have seen a growing interest in the relationship between
wage-setting and monetary regime in economies with large wage-setters.1 The
basic argument is that different monetary regimes involve different reaction
functions of the central bank to the outcome of the wage-setting, which under
most circumstances (to be discussed below) will imply that large wage-setters
face a different trade-off between consumer real wages and employment and
profits. In a regime where the monetary policy dampens the negative effects on
employment and profits of a marginal increase in the consumer real wage, large
wage-setters will choose a high real wage, leading to low levels of employment
and output.
This paper compares two monetary regimes, an exchange rate target and a
consumer price target, in a model with a traded and a non-traded sector. These
regimes are the natural modern options for most open economies, in particular
as exchange rate targeting encompasses membership in a monetary union.
Distinguishing between traded and non-traded sectors is motivated by the idea
that the monetary policy has different effects on these two sectors, a difference
that turns out to be crucial.
The main results are as follows. In the non-traded sector, an exchange rate
target involves higher consumer real wages than does a price target, for the
following reason. Under an exchange rate target, a rise in non-traded wages is
not countered by the central bank, but is allowed to increase non-traded prices.
This dampens the negative effect on employment and profits in the non-traded
sector. In effect, the trade-off between real wages on the one hand and
employment and profits on the other is more favourable, and wage-setters in
the non-traded sector respond by setting a higher wage.
In the traded sector, the ranking is reversed: consumer real wages are
highest under a price target. A wage rise in the traded sector has a
contractionary effect on output and income, reducing demand for the nontraded good and thus also its price. The reduction in non-traded prices implies
that the consumer price target can be realised with a depreciation of the
exchange rate. The depreciation dampens the negative effect on employment
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and profits in the traded sector, making it more attractive to raise the wage.
This mechanism is not present under an exchange rate target.
The feature that the monetary regime has different effects on different
sectors of the economy implies that the monetary regime affects both relative
prices and the sectoral structure of the economy. The moderating effect on
traded sector wage-setting under an exchange rate regime implies that the
price of non-traded goods relative to traded goods is likely to be higher under
an exchange rate target, even in a long-run steady-state equilibrium where
foreign trade is balanced. The effect on the relative size of the two sectors
depends on the elasticity of substitution between traded and non-traded
goods.
As the regimes have different effects on different sectors, the aggregate
outcome depends on which effect dominates. Numerical simulations suggest
that in most cases overall welfare and aggregate employment are higher under
a price target than under an exchange rate target. However, the union in the
non-traded sector benefits from high real wages under an exchange rate target.
Seen from a technical point of view, the results of the present paper are not
surprising. Changing the strategic variable of one of the players (the central
bank) will in general affect the outcome of a game. However, the results are in
sharp contrast to the common view (e.g. Svensson 1997) that in the long run
monetary policy cannot affect real variables, nor can it affect the relative price
of traded versus non-traded goods.
The paper is organized as follows. The model is presented in Section I,
using a theoretical framework drawing upon Rasmussen (1992). To focus on
the long-run effects of the monetary regime, I use a static model with no
shocks. Thus, the model is not suitable for evaluating the stabilization
properties of different monetary regimes.2 Section II explores the equilibrium
of the model, as well as providing results of numerical simulations. Section III
concludes.
I. THE MODEL
The economy under consideration consists of two sectors, with traded and
non-traded goods. In each sector there is a large exogenous number, n, of
identical firms and one union organizing all workers in the sector. Wages are
set at sector level, in a bargain between the union and the employers’
association in the sector. Traded goods have an exogenous world market price
P *, so that the price in domestic currency, P T , is given by P T ¼ EP *, where E
is the nominal exchange rate. Households are either workers or shareholders
(who receive all profits of the firms). Including households in the model
(instead of postulating demand functions directly) has the advantage of
allowing for an explicit welfare comparison of the regimes. Throughout the
paper, all agents are assumed to have perfect information.
The sequence of moves in the model is as follows. First, wages are set
simultaneously in each sector. Second, the central bank sets the exchange rate
so as to ensure that the monetary target is fulfilled. Third, production and
consumption take place.
The reason for distinguishing between the traded and non-traded sectors,
alluded to above, is that the implications of various monetary regimes differ
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sharply between the sectors. It is true that in actual economies the distinction
between traded and non-traded goods is not always sharp. Furthermore, over
time an increasing number of goods have been subject to international trade.
However, it is still the case that a wage rise in the export industry has a
different impact on the consumer price level than a wage rise in the non-traded
sector. It is also the case that a change in the exchange rate has different impact
on output and employment in different sectors of the economy. These are
important distinctions which should be taken into account in a comparison of
different monetary regimes.
The assumption that wage-setting takes place separately in the two sectors
is critical for the results of the paper. If there had been a single, economy-wide
union, bargaining over a common wage for both sectors, the monetary regime
would not matter. With a common wage, the relative price of traded and nontraded goods would be given, and the trade-off between employment and real
wages would be uniquely given from the aggregate labour demand schedule,
unaffected by the monetary regime. In this case, the outcome of the wagesetting would also be unaffected by the monetary regime. This corresponds to
Cukierman and Lippi (2001, Proposition 1(ii)), that at least two unions are
required for the monetary regime to affect wage-setting. Note, however, that
this result is model-dependent: in Bratsiotis and Martin (1999) and Holden
(2001), the monetary regime affects wage-setting and equilibrium unemployment even under complete centralization (i.e. one union), because monetary
policy affects employment directly (via the real money stock), and not only via
the effect on the real wage.
My justification for assuming that wage-setting takes place separately in
the traded and non-traded sectors is that it captures an important element of
realism. In many European countries, large wage-setters are typically industry
unions, some of which belong primarily to the traded sector, while others
belong primarily to the non-traded sector. In Denmark and Norway industry
unions in the manufacturing sector have formed a cartel, while in Sweden and
Finland unions operating in export industries have discussed the formation of
bargaining cartels (Vartiainen 2003).
Households
There is large number, M, of households in the economy, of which M j are
members of the union in sector j, j ¼ T, N, and M M T M N are
shareholders. All households have identical preferences that are separable in
consumption and leisure, and where the subutility function associated with
consumption is of the CES-type. The utility function of household h is
(1)
( 1)=
þ (1 ) 1= (C Th ) ( 1)= ] =( 1) þ (Hh );
Vh ¼ [ 1= (C N
h)
0 < < 1; > 0; 6¼ 1; h ¼ 1; 2; :::; M;
T
where C N
h and C h are the consumption of non-traded and traded goods
respectively, is the elasticity of substitution, and (Hh ) is the sub-utility
function associated with leisure, Hh . To simplify the exposition, I assume that
workers are either fully employed, supplying one unit of labour, where
(Hh ) ¼ 0, or are completely unemployed, (Hh ) ¼ 0 > 0. The budget
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T T
constraint of household h is P N C N
h þ P C h ¼ Ih , where Ih is the nominal
income of household h. Aggregate nominal income h Ih is equal to PY, where
Y is the real aggregate output in the economy and P the consumer price index
that corresponds to the CES utility function (1) (Y j is output in sector j,
j ¼ T; N):
(2)
Y ¼ (P N Y N þ P T Y T )=P;
(3)
P ¼ [ (P N ) 1 þ (1 )(P T ) 1 ] 1=(1 ) :
If the elasticity of substitution ¼ 1, we have the Cobb – Douglas case, where
(4)
Vh ¼
1
a
T 1
(C N
þ (Hh );
h ) (C h )
a ¼ (1 ) 1 ;
0 < < 1; h ¼ 1; 2; :::; M;
(5)
P ¼ (P N ) (P T ) 1 :
It is straightforward to show that utility maximization implies that aggregate
domestic demand for traded goods and aggregate demand for non-traded goods
are
0
1
0 1
N
P
PT
A Y;
(6a)
C N ¼ @
(6b) C T ¼ (1 )@ A Y:
P
P
Firms
The production technology in each sector satisfies (with labour the only input)
(7)
Y j ¼ (1=)(L j ) ;
0 < < 1;
j ¼ T; N;
where L j is employment. (To simplify notation, I do not distinguish between
aggregate and firm-level variables; taken literally, there is only ‘one’ firm in
each sector which nevertheless acts as a price-taker.) The real profits of a firm
in sector j are j ¼ (P j Y j W j L j )=P; j ¼ T; N, where W j is the nominal wage
in the sector.
As seen from each firm, prices and wages are exogenous, and maximizing
profits using (7) results in the labour demand, output supply and real profits as
follows:
(8)
L j ¼ (P j =W j ) 1=(1 ) ;
(9)
Y j ¼ (P j =W j ) =(1 ) 1 ;
(10)
j ¼ (1 ) 1 (P j ) 1=(1 ) (W j ) =(1 ) =P:
Unions
Unions are assumed to be utilitarian in the sense that they maximize the sum of
their members’ utilities. The indirect utility of an employed worker in sector j
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255
(using (1) and (2)) is
(11)
u j ¼ (W j T j )=P;
where T j is the fee paid by union members to the unemployment insurance
fund in the sector. The unemployment insurance fund in each sector is assumed
to be fully financed by fees paid by workers in the sector, so that
T j L j ¼ B j (M j L j ), where B j is the nominal unemployment benefit in sector
j.3 The indirect utility function of an unemployed worker in sector j is
(12)
u jb ¼ B j =P þ 0 :
The sum of utilities of union members (using (11) and (12)) is
(13)
U j ¼ L j u j þ (M j L j )u jb ¼ L j W j =P þ (M j L j )0
¼ (W j =P 0 )L j þ M j 0 :
Monetary policy
Two regimes are considered: a consumer price target P ¼ P G , and an exchange
rate target E ¼ E G .4 The central bank sets the exchange rate so that the
monetary target is always fulfilled, and all agents in the model know that this
will be the case; i.e. there is perfect credibility. A possible interpretation of a
perfectly credible exchange rate target is that the country under consideration
is a small part of a monetary union, while a price target can be made credible
under an independent central bank with a strong reputation. The key part of
the model is that the two monetary regimes involve different response functions
for the central bank; that is, for various outcomes of the wage-setting, the
exchange rate set by the central bank will differ.
Wage-setting
The wage-setting takes place simultaneously in both sectors, so that the
outcome of the wage-setting in one sector cannot affect the wage-setting in the
other sector. As there is no uncertainty, the wage-setters in one sector can
perfectly predict the outcome in the other sector. Formally, there is Nash
equilibrium in a static game between the wage-setters in each sector, as
represented by the Nash maximand.
In the case of a dispute in the bargaining, the union members go on strike,
so that the firm earns zero profits. Workers on strike have no strike pay, so
they have utility 0 . The union part of the Nash maximand is thus
(14)
U j U j0 ¼ (W j =P 0 )L j j;
j¼ T; N:
The payoff of the employers’ association is assumed to be equal to the profits
of the firms. The outcome in the wage-setting is given by the Nash bargaining
solution; that is, W j is set so as to maximize the Nash product
(15)
H j ¼ (U j U j0 ) j ;
J ¼ T; N:
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Substituting out using (8), (10) and (14), the Nash product reads (letting lowercase letters denote natural logarithm)
0
1
j
W
1
1
pj wj
(16)
h j ¼ ln@
0 A þ
1
1
P
0
1
1
1
Aþ
pj wj p
þ ln@
1
1
for j ¼ T; N. Recognizing that both prices are endogenous, the first-order
condition can be solved for the real-wage outcome of the bargaining:
(17)
Wj
P
1þ2
¼
2 2
dp j
dw j
dp j
dw j
þ (1 )
þ 2(1 )
dp
dw j
dp
0 ;
j ¼ T; N:
dw j
The monetary regime affects the real-wage outcome via the effect on dp j =dw j
and dp=dw j , i.e. the effects of a wage rise on the own-sector price and the
consumer price. To the extent that a wage rise in one sector leads to
higher prices in the same sector, dp j =dw j > 0, this dampens the negative effect
on employment and profits of a wage rise. Thus, this effect will lead the
wage-setters to agree on a higher real wage. To the extent that a wage rise
leads to higher consumer prices, the purchasing power of money wages and
profits is reduced. This effect makes the wage-setters agree on a lower real
wage.
II. EQUILIBRIUM
Equilibrium of the model is a situation in which households choose
consumption so as to maximize their utility; firms set employment so as to
maximize their profits; the central bank sets the exchange rate to achieve the
monetary target; the sectoral wage is set in a Nash bargain in each sector; and
the price of non-traded goods is given by the market-clearing condition
(18)
C N ¼ Y N:
From the budget condition of the households, it follows that there is balanced
trade, Y T ¼ C T , in equilibrium. To derive the equilibrium, we must explore the
marginal impact on the various prices of a wage rise, to be inserted into the
solution for the outcome of the wage bargaining (17). The impact varies across
monetary regimes, and this is the topic of the next subsections.
Exchange rate target
Under an exchange rate target, the price of traded goods is not affected by the
wage-setting, so dp T =dw T ¼ dp T =dw N ¼ 0. However, a wage rise will affect the
price in the non-traded sector, and therefore also the consumer price level.
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257
Consider first wage-setting in the traded sector. (All derivations are in the
Appendix.)
(19)
dp
dw T
¼
E < 0;
þ (1 )
where
0
(20)
i @
P NY N
PY
1
0
A ¼ @
PN
P
11 A
;
i ¼ E; P;
is the equilibrium share of non-traded goods of total nominal output under
monetary regime i: E (exchange rate) and P (price target). (The latter equality
in (20) can be derived from (6a), using C N ¼ Y N in the steady state.) As is
apparent from (20), i varies across regimes because the equilibrium values of
P N =P, Y N and Y differ between the regimes.
The mechanism behind (19) is as follows. Higher wages in the traded sector
reduce traded sector output, so that aggregate output and income are reduced.
When households’ income goes down, they reduce their demand for nontraded goods, inducing a reduction in the price on non-traded goods, and thus
also a reduction in consumer prices.
Turning to wage-setting in the non-traded sector, we have
(21)
(22)
dp N
dw N
dp
dw N
¼
¼
þ (1 )
E þ (1 )
> 0;
> 0:
Higher nominal wages in the non-traded sector lead to both higher prices on
non-traded goods and higher consumer prices, owing to the negative effect on
the supply of non-traded goods (although the price increase is dampened by the
negative income effect because of the reduction in output).
Price target
Under a target for the consumer price level, wage rises may affect prices in both
sectors. However, the central bank adjusts the exchange rate so that the consumer
price level is equal to the target, and is thus unaffected by the wage-setting; i.e.
dp=dw T ¼ dp=dw N ¼ 0. Consider first wage-setting in the traded sector:
(23)
dp T
dw T
¼
P þ (1 )
> 0:
Higher nominal wages in the traded sector lead to higher prices on traded goods,
via the following mechanism. Higher wages in the traded sector reduce traded
sector output, so that aggregate output and income is reduced. When households’
incomes go down, they reduce their demand for non-traded goods, inducing a
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reduction in the price on non-traded goods, with a corresponding dampening
effect on consumer prices. To maintain the price target, the central bank
depreciates the currency, so that traded sector prices increase as measured in
domestic currency.
Turning to the non-traded sector, we have
(24)
dp N
dw N
¼
(1 P )
þ (1 )
> 0:
Higher nominal wages in the non-traded sector lead to higher prices on nontraded goods, owing to the negative effect on supply.
Comparing regimes
A direct comparison of the effect of the monetary regime is made difficult by
the fact that the share of non-traded output of total nominal output (E or P )
depends on the monetary regime. This problem is circumvented in the Cobb –
Douglas case, where the share of non-traded output is the same in all regimes,
E ¼ P ¼ ; cf. Proposition 1.
Proposition 1. In the Cobb – Douglas case, ¼ 1; the consumer real wages in
the traded sector and non-traded sectors, W T =P and W N =P, are given by
W T 1 þ (1 )
0 ,
under an exchange rate target,
E ¼ EG ¼
2 2(1 )
P W T 1 þ 2
0 ,
under a price target,
P ¼ PG ¼
2 2
P W N 1 þ 0 ,
under an exchange rate target,
E ¼ EG ¼
2
P W N 1 þ 2
0 ,
under a price target.
P ¼ PG ¼
2
P The ranking of consumer real wages is
W T W T P ¼ PG >
E ¼ EG
P P W N W N P ¼ PG <
E ¼ EG
P P while the ranking of relative wages is
W N W N P ¼ PG <
E ¼ EG
WT WT # The London School of Economics and Political Science 2003
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WAGE-SETTING UNDER DIFFERENT MONETARY REGIMES
259
Thus, in the traded sector consumer real wages are higher under a price
target than under an exchange rate target. The intuition behind the ranking
builds on the fact that the highest real wage is set in the monetary regime that
provides the wage-setters with the most favourable trade-off between real
wages on the one hand and employment and profits on the other. Under a price
target, a wage rise in the traded sector has a contractionary effect on output
and income, reducing demand for non-traded goods and thus reducing nontraded prices. This gives room for a depreciation of the exchange rate,
mitigating the negative effect on employment and profits. Under an exchange
rate target there is no such offsetting effect.
In the non-traded sector, consumer real wages are highest under an
exchange rate target. This reflects the fact that under an exchange rate target a
wage rise in the non-traded sector is allowed to feed into higher non-traded
prices, mitigating the negative effect on employment and profits. The
counteracting effect via the increasing consumer prices is less important.
The ranking of relative wages follows directly: non-traded wages are higher
under an exchange rate target, while traded wages are higher under a price
target. To derive the ranking of relative prices, we use (18) and the budget
condition to get
(25)
CN
CT
¼
YN
YT
:
Substituting out for (6a,b) and (9), and rearranging, we get
0
1=(1 ) 0
1=(1 ) þ WN
PN
@
A
A
¼@
:
(26)
WT
PT
Inspection of (26) reveals that P N =P T is strictly increasing in W N =W T . From
Proposition 1, it is then immediate that
Proposition 2. In the Cobb – Douglas case, the ranking of relative prices
satisfies
P N P N E ¼ EG >
P ¼ PG:
PT PT Thus, prices of non-traded goods relative to traded prices are higher under an
exchange rate than under a price target. The intuition is that the high nontraded wages under an exchange rate target decreases the supply of non-traded
goods, raising non-traded prices. In contrast, a price target also keeps wages
down in the non-traded sector.
Numerical solutions to the model
In this subsection I explore further the difference between the monetary
regimes by use of numerical simulations of the model, based on equations (3),
(17), ( j ¼ T; N), (20) and (26). The numerical simulations show the sensitivity
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to the parameter values, as well as allowing for an additional feature that sheds
light on the overall robustness of the conclusions (see below).
Because of the highly stylized nature of the model, the magnitudes of the
differences cannot be taken seriously. Yet the simulations provide a rough
indication of the effects that are at work. Comparing columns in Table 1
pair-wise, a number of features are apparent.
1. The results of Propositions 1 and 2 show up in the CES cases too: a price
target leads to higher real consumer wages in the traded sector, while an
exchange rate target leads to higher real consumer wages in the non-traded
sector, as well as higher non-traded prices relative to traded sector prices.
2. In the CES cases, the relative size of the sectors depends on the monetary
regime. For < 1, the higher relative prices on non-traded goods under an
exchange rate target implies that the non-traded sector constitutes a larger
share of the overall economy, E > P . For >1, the effect is reversed.
3. The union in the non-traded sector gains from an exchange rate target
(owing to high real wages), whereas the union in the traded sector, as well as
employers in both sectors, generally gain from a price target.
4. In most cases a price target is superior, resulting in higher household utility
and higher aggregate output and employment.
5. Modifying the sharp sectoral split of the unions reduces the differences
between the regimes, but does not affect the qualitative results (columns
¼ 0:95 in Table 1). In this simulation, 1 of the members in each union
are assumed to work in firms in the other sector, yet there is a common
wage for all workers in the same union. Thus, the employment of, say,
TABLE 1
NUMERICAL SIMULATIONS
Basis
OF THE
MODELa
= 0.8
=2
¼ 0:95
Var.ntarget
CPI
Exch.
CPI
Exch.
CPI
Exch.
CPI
Exch.
W N =P
W T =P
P N =P T
i ; i ¼ P; E
L
Y
YN
YT
V ¼ Y L0
UN
UT
N
T
0.75
0.75
1.00
0.50
4.74
5.33
2.67
2.67
2.96
0.59
0.59
0.89
0.89
1.00
0.70
1.27
0.50
3.47
4.29
1.90
2.41
2.55
0.71
0.41
0.71
0.71
0.77
0.77
1.00
0.50
4.39
5.07
2.54
2.54
2.87
0.59
0.59
0.85
0.85
1.19
0.71
1.45
0.52
2.60
3.51
1.52
2.04
2.21
0.70
0.33
0.61
0.56
0.70
0.70
1.00
0.50
5.83
6.12
3.06
3.06
3.21
0.58
0.58
1.02
1.02
0.75
0.68
1.06
0.49
5.50
5.88
2.78
3.10
3.13
0.64
0.53
0.95
1.01
0.72
0.72
1.00
0.50
5.34
5.77
2.89
2.89
3.10
0.59
0.59
0.96
0.96
0.80
0.68
1.12
0.50
5.01
5.53
2.64
2.89
3.02
0.69
0.49
0.93
0.91
a
Basis simulation: ¼ 1, ¼ 0:5, ¼ 2=3 and 0 ¼ 0:5. The other columns show effects of changing
one of the parameters relative to the basis simulation. ¼ 0:95 indicates that a share 1 ¼ 0:05
of the workers organized in the traded (non-traded) sector union work in the non-traded (traded)
sector (see explanation in main text). In the figures for household and union utility, V and U j , the
constant term M j 0 is left out.
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WAGE-SETTING UNDER DIFFERENT MONETARY REGIMES
members of the traded sector union working in the non-traded sector
depends on the real wage W T =P N (details in the Appendix). The effect is
that unions also take into consideration the employment effects of the price
in the other sector, and this mitigates the strategic effects of the monetary
regime.
6. Somewhat surprisingly, exchange rate targeting involves higher welfare and
output when the non-traded sector is by far the larger (Table 2, ¼ 0:9).
Under price targeting, the smaller traded sector union exploits the strategic
advantage of being small, in the sense that the aggregate effects of a
high wage in the small sector are not so large. (This corresponds to
the findings of Hersoug 1985, with the telling title ‘The importance of
being unimportant — on trade unions’ strategic position’.) Thus, the wage
moderating effect of exchange rate targeting in the smaller traded sector
dominates the wage moderating effect of price targeting in the larger nontraded sector.
III. CONCLUDING REMARKS
A recent literature has shown that the choice of monetary regime influences the
equilibrium rate of unemployment in an economy with large wage-setters, by
affecting the slopes of the trade-offs between consumption real wages and
employment=profits. This paper extends this literature by comparing exchange
rate targeting with consumer price targeting. It is shown that traded sector
wages are likely to be higher under a price target than under an exchange rate
target. The reason is that an increase in traded sector wages has a dampening
effect on non-traded prices (via a negative income effect in the demand), and
under a price target the dampening effect on non-traded prices provides room
NUMERICAL SIMULATIONS
OF THE
¼ 0:1
TABLE 2
MODEL: THE EFFECT
THE SECTORS
¼ 0:25
OF THE
RELATIVE SIZE
= 0.75
OF
¼ 0:9
Var.ntarget
CPI
Exch.
CPI
Exch.
CPI
Exch
CPI
Exch.
W N =P
W T =P
P N =P T
i ; i ¼ P; E
L
Y
YN
YT
V ¼ Y L0
UN
UT
N
T
1.75
0.64
0.94
0.10
4.06
4.16
0.44
3.72
2.13
0.20
0.54
0.14
1.25
4.00
0.64
1.63
0.10
3.38
3.53
0.23
3.34
1.84
0.21
0.46
0.12
1.06
1.00
0.67
0.91
0.25
4.43
4.83
1.30
0.81
2.62
0.40
0.60
0.40
1.21
1.75
0.66
1.33
0.25
3.18
3.72
0.75
2.99
2.13
0.44
0.45
0.31
0.93
0.67
1.00
1.10
0.75
4.43
4.83
3.54
1.30
2.62
0.60
0.40
1.21
0.40
0.75
0.75
1.44
0.75
4.16
4.68
3.20
1.54
2.60
0.78
0.26
1.17
0.39
0.64
1.75
1.06
0.90
4.06
4.16
3.72
0.44
2.13
0.54
0.20
1.25
0.14
0.67
0.79
1.86
0.90
4.45
4.52
3.82
0.79
2.29
0.68
0.11
1.36
0.15
Notes: see Table 1.
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for a depreciation of the currency. The depreciation mitigates the negative
effects on employment and profits of a wage rise in the traded sector, leading
wage-setters to agree on higher wages. On the other hand, wages in the nontraded sector are likely to be higher under an exchange rate target than under a
price target. Under an exchange rate target a wage rise in the non-traded sector
is fully reflected in non-traded prices as well as in the consumer prices.
Although wage-setters dislike the increase in the consumer prices, this is
outweighed by the increase in non-traded prices, which mitigates the negative
effects of a wage rise on employment and profits.
An important consequence of the model is that the monetary regime affects
relative prices and the sectoral structure of the economy. Higher non-traded
wages under an exchange rate target implies that non-traded prices are higher,
relative to the price of traded goods, even in steady-state equilibrium where
foreign trade is balanced. The effect on the relative sizes of the sectors depends
on the elasticity of substitution between traded and non-traded goods. If the
elasticity of substitution is above unity, low traded sector wages under an
exchange rate target stimulate production in the traded sector, while high nontraded wages dampen production in the non-traded sector. This is in contrast
to the common view (e.g. Svensson 1997) that in the long run monetary policy
cannot affect real variables, nor can it affect the relative price of traded versus
non-traded goods.
The results depend on the wage-setting being non-atomistic. If wage-setting
is sufficiently decentralized so that the aggregate variables are exogenous to the
individual wage-setter, then the regimes are identical in the present model.
However, in many European countries some wage-setters are big enough to
have a non-negligible impact on aggregate variables. Furthermore, unions
are usually organized along industry lines, so that some would have a
concentration of members in the traded sector and others, a concentration of
members in the non-traded sector. This may suggest that the effects studied in
this paper are also of considerable empirical relevance.
An interesting extension of the model would be to endogenize the capital
stock. Although a proper analysis is beyond the scope of this paper, it seems
likely that some of the above results might be exacerbated. A high real wage in
one sector implies that the return to capital is low, leading to less investment in
this sector. It seems likely that under an exchange rate target capital would
flow out of the high-wage non-traded sector and into the low-wage traded
sector, thereby reducing non-traded production while increasing traded
production. Under a price target, capital may flow in the opposite direction.
The results of the numerical simulations are in most cases favourable to a
consumer price target regime, as this regime involves higher aggregate output
and higher household utility. Now one should be very careful in drawing policy
conclusions from numerical simulations of a stylized model as in the present
paper. However, it appears that the main reason for this result is that an
exchange rate target provides insufficient incentive to impose wage restraint in
the non-traded sector. A possible policy implication is that countries with
powerful unions in the non-traded sector should adopt a price target rather
than an exchange rate target.
The results of this paper should also be of interest to a country with strong
unions that is contemplating entering the EMU. (Sweden is an obvious
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WAGE-SETTING UNDER DIFFERENT MONETARY REGIMES
263
example.) For a single country, EMU involves an exchange rate target, in the
sense that a wage rise in the non-traded sector will feed into higher non-traded
prices with negligible reaction from the central bank. Thus, the argument in
this paper indicates that membership in the EMU may lead to a higher
equilibrium rate of unemployment (as also argued by Soskice and Iversen,
1998, and Cukierman and Lippi, 2001) than an independent inflation target.5
However, an effect not identified by Soskice and Iversen and Cukierman and
Lippi is that membership in the EMU will lead to wage moderation in the
traded sector, and thus will strengthen this sector. Numerical simulations
suggest that unions in the non-traded sector benefit from an exchange rate
target (as EMU), while other agents lose.
APPENDIX
To derive the effect of a wage rise on the various prices, we explore the effect on the
market for non-traded goods. Substituting out in (18) for (6a), (2) and (9), we obtain (in
log form)
(A1)
1
(p N w N ) ln ¼ ln i (p N p)
T
T
þ ln([(e p ) 1=(1 ) (e w ) =(1 ) 1
N
N
þ (e p ) 1=(1 ) (e w ) =(1 ) 1 ]=e p ):
By total differentiation with respect to wages and prices, and rearranging, we get
(A2)
[ þ (1 ) i ]dp N (1 i )dw N
¼ (1 i )dp T (1 i )dw T (1 )(1 )dp:
Consider first the effect of a marginal increase in w T under an exchange rate target.
Thus, we set dp T ¼ dw N ¼ 0, so that (A2) simplifies to
(A3)
[ þ (1 ) i ]dp N ¼ (1 i )dw T (1 )(1 )dp:
To solve for the effect on consumer prices, we need to substitute out for dp N . From the
definition of the consumer price level (3), total differentiation yields (in log form)
(A4)
dp ¼ i dp N þ (1 i )dp T ;
Under an exchange rate target, the price of traded goods is constant, so that there is a
simple relationship between changes in prices on non-traded goods and changes in
consumer prices:
(A5)
dp ¼ i dp N :
Substituting out for dpN in (A3), using (A5), and rearranging, we obtain (19) in the main
text. Equations (21) and (22) are derived correspondingly.
Consider then the effect of a marginal increase in w T under a price target. Thus, we
set dp ¼ dw N ¼ 0, so that (A2) simplifies to
(A6)
[ þ (1 ) i ]dp N ¼ (1 i )dp T (1 i )dw T :
Under a price target, the central bank must set the exchange rate so that changes in the
prices of traded and non-traded goods balance each other. From (A4), dp ¼ 0 entails that
(A7)
i dp N ¼ (1 i )dp T :
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ECONOMICA
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Substituting out for dpN in (A6), using (A7), we obtain (23). Equation (24) is derived
correspondingly.
The sensitivity with respect to the split of unions along traded=non-traded lines
The motivation for this simulation is to explore the sensitivity to the split of the unions
along sectoral lines. Specifically, in this simulation it is assumed that 1 of the
members in each union work in firms in the other sector, yet there is a common wage for
all workers in the same union.6 The unions bargain with employers’ associations
representing the firms for which their members work. To obtain tractable solutions, I
assume that union utility is a geometric average of the utility of the members employed
in the two sectors, with the shares as weights, while the employers’ association
maximizes the geometric average of the profits of the firms in the two sectors. The Nash
product is now
(15)
H j ¼ (W j =P 0 ) (L j ) (W g =P 0 ) 1 (L g ) 1 ( j ) ( g ) 1 ;
j; g ¼ T; N; j 6¼ g;
where L ¼ (P g =W j ) 1=(1 ) is labour demand for workers located in firms in the ‘other’
sector. For tractability, I also approximate production in each sector as the geometric
average of production in firms with workers from different unions, i.e. that
g
Y j ¼ (P j =W j ) =(1 ) (P j =W g ) (1 )=(1 ) ; j; g ¼ T; N; j 6¼ g:
The further analysis is as in the main case. As shown in the simulations, the effect of this
assumption is that unions also take into consideration the employment effects of the
price in the other sector, and this mitigates the strategic effects of the monetary regime.
ACKNOWLEDGMENTS
I wish to thank Larry Ball, Eivind Bjøntegård, Kai Leitemo, Jørn Rattsø, Asbjørn
Rødseth, Erling Steigum, Fredrik Wulfsberg and an anonymous referee, as well as
participants at presentations at EEA 1998 in Berlin, Norges Bank, Aarhus University,
the Institute for International Economics, Stockholm, and staff members at the
Departments of Economics at NTNU (Trondheim), University of Oslo, University of
Copenhagen and University of Hamburg for helpful comments. The views expressed are
my own, and do not necessarily reflect those of Norges Bank.
NOTES
1. Early contributions are Horn and Persson (1988), Holden (1991), Akhand (1992), Sørensen
(1992) and Jensen (1993), while the more recent literature includes Bratsiotis and Martin (1999),
Soskice and Iversen (1998, 2000), Wibaut (1998), Cukierman and Lippi (1999, 2001) and
Holden (2001). A related literature, following Cubitt (1992), shows similar mechanisms under
the assumption that unions are also concerned about inflation.
2. Leitemo and Røisland (1998) find that CPI– inflation targeting is likely to outperform fixed
exchange rate regimes in terms of stabilization properties.
3. As is apparent from equation (13) below, the level of benefits B does not matter when they are
fully financed by the workers in the sector and utility functions are linear.
4. As the model is static, and none of the specified agents are assumed to care about inflation per se,
a price-level target is identical to an inflation target.
5. On the other hand, in Holden (2001) I argue that membership in the EMU may strengthen the
incentives for wage-setters to coordinate their wage-setting, as the consequences of failing to
coordinate are more damaging when there is no country-specific central bank to discipline wagesetting.
6. Obviously, this implies that otherwise identical firms, producing the same homogeneous good,
employ workers with the same productivity, who nevertheless are organized in different unions
and thus are paid differently. This scenario raises several new issues, but is outside the scope of
this sensitivity analysis.
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265
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